Solar Financing – Part 3: Third Party Ownership

In the distributed generation world, TPF is a financing structure that provides a workaround to the limits placed on tax equity funding by a developer’s tax appetite. It allows the solar/storage developer to reap the benefits of the tax equity provided by the incentives described in Part 2 (or other related incentives) by going through a third party financier. When the financier is used for this purpose specifically they are called a tax equity financier. This is accomplished essentially by the developer trading ownership with the financier (who has a much larger tax appetite). The topic of this post will be the three primary routes by which TPF is accomplished: sale-leasebacks, partnership flips, and inverted leases (summarized form Woodlawn Associates).

First, there are three primary players and a few key terms to be defined:

Players

Developer: The solar or storage developer in charge of identifying and executing the project.

Tax Equity: This is the financial party to which the project ownership is transferred in order to take full advantage of the tax credits.

Customer: The beneficiary/ host of the project who will be receiving the energy or value of the energy, likely through a lease or PPA.

Key Terms

Fair Market Value (FMV): This is generally defined as the price at which an asset would change hands between a willing buyer and a willing seller given both have reasonable knowledge of all the relevant facts. There are three commonly accepted ways to determine this value: (1) income – the income that will be generated by the asset; (2) market – the cost of similar assets on the market; (3) cost – the cost to develop or replace the asset.

Special-Purpose Entity (SPE): A legal entity created to carry out only a specific set of tasks. By limiting the SPE’s operations, they can isolate financial risk from their parent company, and therefore are often used for complex financing situations.

Sale-Leaseback

The sale-leaseback is the simplest of the three financing structures where the Developer contracts with a Customer before handing it off to the Tax Equity firm, who acts as the middleman. Steps 2 & 3 relate to the financing transaction, while 1 & 4 are standard to any developer-customer transaction.

Allows full transfer of tax benefits to Tax Equity (because the purchase price associated with the tax benefits is now based off of the Developer-Tax Equity transaction, which often includes a marked up development cost, the benefits will be correspondingly larger).

Minimal financing required from Developer.

Buffer time between system completion and financing structure (90 days).

Cons:

Most of the capital comes from Tax Equity. Because the cost of capital from Tax Equity is usually high compared to other forms of financing, this can lead to an inefficient financing structure.

Depending on the structure of the Developer-Tax Equity and Developer-Customer contracts, the developer can be exposed to significant performance risk.

Developer loses ownership. If they want to reclaim ownership at the end of the lease, they will have to pay FMV (contract must be structured such that FMV is 20% at the end of the lease).

Partnership Flip

Under this financing structure, the Developer (sometimes called “Sponsor” in this scenario) and Tax Equity partner to form the Project Company, a joint venture SPE made specifically to own the development and allow transfer (“flips”) of distribution of profits, cash, and benefits back and forth between the parties. The Project Company is organized as an LLC so that income taxes are paid on the entities individual corporations as opposed to the Project Company.

The “flips” provide the means for the general functions of a Sale-Leaseback, without a complete transfer of ownership. A common partnership is split into two phases. (1) The vast majority of tax benefits, profits, and losses are allocated to Tax Equity (the distributions of profit and tax benefits do not have to match). Over this period there are usually losses, which reduces Tax Equity’s corporate tax payments. (2) After a minimum of 5 years, the allocations “flip” such that Developer receives the majority of the attributes. If the flip is executed before year 5, a portion of the tax benefits will be recaptured by the government. After the flip, Developer often has the option to buy out Project Company.

There are two primary categories of these flips: (1) Yield-based flips are subject to the performance of the assets; the flip does not occur until Tax Equity meets its predetermined return – these are the most common; (2) Fixed flips are not conditional on a specific return being met, rather they flip at a predetermined date regardless of performance – these are less common and make most sense when tax rates are very stable.

Project company distributes the tax benefits (usually ~99%) and enough cash to meet the target IRR to Tax Equity (cash is not synonymous with profit). The remaining tax benefits and cash is distributed to Developer.

Assets and attribute “flip” to a new distribution after tax benefits have been used/ Developer buys out Project company.

Pros:

The structure is well established and is widely used in renewables.

Reasonable buyout price for the developer after the flip.

There are rarely fixed payments meaning that under will not have direct monetary costs but rather will cause a delayed flip.

Cons:

Requires a much larger capital investment from Developer than a Sale-Leaseback.

Maintains a slight risk to the tax appetite of Developer.

Developer must enter the partnership prior to the assets being installed.

High overhead, especially in legal and accounting.

Inverted Leases

There are two types of inverted leases which are structured differently so they will be broken down separately. These inverted leases are basically inverted forms of the two structures we already discussed which keep ownership in the hands of Developer. The first is a Simple or Clean inverted lease and the second is a Partnership inverted lease.

Figure 3: Inverted Lease (Simple) Diagram

Steps (Simple/Clean):

Tax Equity leases the system from Developer, allowing the Tax Equity to receive 100% of the incentive.

Tax Equity makes lease payments to Developer.

Customer makes scheduled payments to Tax Equity.

After the lease term ends, Customer pays Developer directly.

Steps (Partnership): The primary role here is to allow Developer to keep nearly half the tax benefits. For this reason it is not as favorable to Tax Equity financiers. Two new SPE’s are created in this TPF agreement, the Master Tenant and the Owner/Lessor.

Developer and Tax Equity fund a new entity called the Master Tenant (similar to the Project Company). Tax Equity funds the vast majority (~99%) of Master Tenant.

Developer and Tax Equity fund another new entity called the Owner/Lessor which takes ownership of the solar system. Structured such that Developer is the majority owner (~51%).

Owner/Lessor provides capital to Developer.

Owner/Lessor leases system to Master Tenant, passing the ITC benefits over as well.

Master Tenant subleases to Customer in exchange for scheduled payments. Master Tenant passes some of this payment to Owner/Lessor.

After lease term ends, Customer pays Owner/Lessor directly.

Developer and Tax Equity take ITC benefits proportional to their ownership of Master Tenant (~1:99 respectively).

Developer and Tax Equity take depreciation benefits proportional to their ownership of Owner/Lessor (~51:49 respectively).

Pros:

Developer keeps some of the depreciation benefits (not always a pro).

Because the recipient of the ITC is a lessee and therefore has no insight into the actual cost of the project, ITC amount is based off of the FMV according to the appraised value of the transaction.

Cons:

The lowest portion of tax benefits go to Tax Equity in this structure.

Highest tax structuring risk.

This is not a common structure and is usually unfavorable to Tax Equity.

These posts show the wide spectrum of difficulty that can be involved in getting solar financed and installed. I haven’t included all the considerations, yet it is clear a standard homeowner looking to put some panels on their roof already has some tough decisions. Further, the complexity of the decision tree for a developer of large commercial or industrial projects grows exponentially. What is the limit to cost of installation, O&M, and other overhead to meet my desired rate of return? How much funding will be required and where will it come from? Who is going to take the tax benefits? Which tax benefits even make sense given their limitations? The ramifications of these complex considerations are what determine the financeability of a project. They may not be a necessity for everyone in renewables to understand, but a grasp of the fundamentals can prove to be very useful.